The Value of Cash

On our recent roadshow tour, many intelligent questions were asked about the current cash weightings. Is it reflective of our thoughts on value available in stockmarkets? Does it mean we expect an imminent downturn? Wouldn’t returns be better if the Fund was 100% invested all the time? Why should I invest in your funds today if a large part sits around doing nothing?

They’re good questions. I’ll answer most here, although Steve has promised to specifically address that last one in a post soon.

Yes, higher cash weightings are at least in part reflective of our opinion on value. As a base, we view anything around 10-15% cash as fully invested. A 30% weighting is telling you something.

When markets are frothier, we’re likely to do more selling than usual as more of our positions move from underpriced to fairly priced. A strong sell discipline is important to risk-adjusted returns over time.

The quality of ideas counts

The world isn’t devoid of good investment ideas. In the International Fund (my purview), we have been finding quite a few new investments recently.

A few years ago we could buy high-quality small cap businesses below 12 times earnings (see B&C Speakers and El.En. for example). The cheap stocks available today are more likely to be cyclical, lower quality and/or more complicated. These mispriced bets deserve a place in your portfolio. But they are not the sort of businesses to invest in heavily.

Absent low risk outright bargains, quality blue chip stocks bought at reasonable prices can be a useful hiding hole. They won’t shoot the lights out but they’ll do better than cash over time. The current International Fund portfolio contains a smattering, including Google owner Alphabet, Lloyds Bank and Baidu. A few more would be great. Despite a long list of targets, ‘at reasonable prices’ has been the sticking point.

Cash as a weapon

Then there is the upside from holding cash. Being 100% invested all the time is likely to beat being 70% invested all the time. But what about being 70-80% invested when bargains are harder to find, and 100% invested when bargains abound? That works well. The drag from holding cash for reasonable periods of time can be more than offset by the rewards that come from putting it to work in times of distress.

Which gets to the heart of our thoughts on the matter. Cash isn’t laziness but preparedness. It provides useful protection in falling markets. Perhaps more crucially, cash is a potent weapon if used correctly.

The International Fund’s cash exposure over the past 31 months is instructive.

There have been three decent market dislocations over the past few years. Calendar year 2015 started with high cash balances, similar levels to what’s in the portfolio today. The first big ruction came around August 2015, sparked by fears in China but it quickly spread to be one of the bigger downturns in Western markets over the past five years. Our cash weighting fell from 30% to below 15% in a few months as the Fund loaded up on good investment ideas.

An even bigger China wobble came in the first months of 2016. Cash holdings dipped below 3% at one stage in early-February. A month later, as panic subsided and some of the holdings reached fair value, it was back at 10%.

Then Brexit happened, and the Fund pounced on a few more opportunities.

At 30 June 2015, we didn’t know what the future would bring. But the prospects available at the time weren’t compelling. And having a large cash weighting allowed the Fund to make the most of the pessimism that soon emerged.

Stocking up

Over the following year the Fund bought El.En which subsequently tripled and Sotheby’s which almost doubled before we sold it. We bought into South32 around $1.50 in July 2015 and doubled down below $1.00 in early 2016. The Fund bought Cable One and sold out for a 50% profit in barely a year.

These investments were crucial contributors to the excellent results over the past few years. And had the Fund gone into that period without substantial firepower in the form of cash, it’s most unlikely results would have been as good. Selling cheap to buy cheaper is much tougher game than raiding the bank account when the bargains emerge.

High average cash balances over time aren’t lazy unless they’re permanent. If we prove prescient and nimble enough to put that cash to work at times of volatility and fear, even if for only short periods of time, it will prove worthwhile. It’s a litmus test you might want to apply to us and other cash-hogging money managers in the years ahead. Is that cash put to work occasionally? Do the stocks bought in those periods add meaningfully to returns?

We don’t know what the future brings or whether a downturn is imminent. But fear and volatility haven’t been permanently banished. The currently high cash weight in both Funds is preparation for when such negativity returns.

Gareth,
I totally agree, having amo in the bank and buying a quality company for say 20% discount, which is viewed as temporary, is a bargain and a 20% PROFIT. This is one of the reasons the team has produced such great results. WELL DONE.

Yes, I agree completely. And perhaps equally as important, funds that have a mandate to remain 100% invested are required to continue to invest regardless of the value of the stocks on offer. So in the case of an extremely overheated market, where absolutely no value exists, the fund will continue to fill it’s portfolio. Just imagine what the value of the last entry into the fund would look like !! Yikes. I can speak from personal experience on this – being at the receiving end of a managed fund in this position (I am somewhat wiser now) and I can assure you that the result was not pretty????

Gareth, I’m a little bit confused. For fund managers to hold (more than) healthy levels of cash makes sense. As a SMSF trustee holding about 10% cash levels, I’d appreciate your comments. If the fund holds a number of shares which are producing acceptable levels of dividends at cost prices well below current share prices, does it make the individual investor wrong to hold such seemingly low cash levels ? I guess it would be like a property owner in WA that purchased their IP years ago or purchased their last CBA shares @ $26.00. To sell good investments just to raise cash levels doesnt appear to make good sense; although I appreciate that having an investment in Forager as part of a diversified portfolio would make good sense.

I agree with your approach. I sold out entirely on 14 December 2007, and lost not one cent during the GFC as a result, while I had massive access to cash to play the 2009 rally. I sold out of that prematurely at the end of that year (2009), which was a bit too early, but made much money as a result of timing the market well a second time. Subsequently I have never been in cash completely (I also invest in corporate bonds), but made excellent money in the market again starting early in 2012, when banks were cheap because people had been too confident about 2011 ending high. In other words, your point that it is important to have cash when really good opportunies arise is demonstrably right. As important, to me, is not to lose money I have made, so I sell when I see a significant decline emerging that might wipe out money I might hold in shares. My approach is somewhat extreme, but it has proved very profitable. As fund managers, you people are in a different position, but I think that having e.g. 30% in cash much of the time to employ that really well when you see good opportunities is a good idea, and it softens big losses if you were to get overtaken by a sudden crash hitting almost all shares. Many investors don’t invest for many years, and thus don’t think they can really lose. But those who bought high in 2007, and invested in the index at the time, still haven’t recovered all the money they lost during the ensuing crash.

In downturn/bloodbath, your investors may want their monies back, hence you may be forced to return a large part of your cash pot. Your investors are same people as other investors. All are a genius when things are moving sideways and up. Sorry, for the rant but you need to think about the outflow of money during the crisis.

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Forager Funds Management provides general information to help you understand our investment approach. Any financial advice we provide has not considered your personal circumstances and may not be suitable for you.

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